Step 6: Style Drifters

Style Drifters
Comprehend active management style drift

6.2

Definitions


6.2.1

Investment Style

Investment professionals and academics use many terms to define risk. These include markets, benchmarks, asset classes, styles, style boxes, investment objectives, risk factors, market dimensions, market segments, buckets of stocks, rules of ownership, slices of the market, industry classifications, and indexes such as Dow Jones Indexes, Standard and Poor's Indexes, Russell Indexes, Wilshire Indexes, Morgan Stanley Capital Indexes, Wired Index, and many more. Style is just one of many terms used. It is simply a classification of an investment's risk characteristics. Investments can be grouped into several criteria or dimensions.

Stocks of a particular style generally share long-term risk, return, and correlation characteristics. This helps investors and financial planners decide how to allocate their assets. An equity fund's style refers to the types of stocks the fund holds.

Active mutual fund managers define their own investment style, which guides them in picking individual stocks. For example, a fund manager may manage a growth fund that reflects a style preference of growth stocks.

The problem with investment style is that it is not consistently defined within the industry. Terms such as large, small, value, and growth have a wide range of definitions. This lack of specificity makes it difficult for investors to measure their risks and rewards, and easier for active managers to claim market beating returns over a nebulous benchmark.

A growth style includes stocks that are experiencing rapid growth in earnings, sales, or return on equity. Growth stocks tend to carry low book-to-market ratios, high price earnings ratios, and usually offer no dividend yields. Growth stocks are priced much higher than their book values, indicating a large portion of the purchase price goes to goodwill. Goodwill is basically the difference between the price and the book value. Growth is somewhat of a misnomer. The price paid for goodwill is often deflated by news of lower than expected earnings growth of these companies. Growth stocks are expected to underperform value stocks and the total market.

A value style includes stocks that tend to carry high book-to-market ratios, low price earnings ratios, high dividend yields, and are often described as being in distress. They are thus perceived by investors to be of higher risk, but investors need to remember that higher risk equates to higher expected return. The shareholders of value stocks have a high cost of capital, which equates to a higher expected return for the capital provider. The capital provider is the investor, or the capitalist. Value stocks may receive a lot of negative publicity and experience a downturn in their business.

The styles of large, small, and micro are based on a company's share price multiplied by the total number of shares. Companies are ranked and grouped into categories that vary substantially within the investment industry. For example, as of September 2001, the Russell 2000 index of small cap stocks had a weighted average market cap of $800 million, while the DFA small cap index had $600 million, and the DFA Micro cap index had $250 million. Morningstar, Russell, Lippers, Barra, Wilshire Associates, DFA, Morgan Stanley Capital Indexes, and Standard and Poor's are all considered reliable sources of style criteria. Each has its own set of rules for measuring value, growth, large, small, international, or emerging markets. It is no surprise that the active investor is dazed and confused.


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6.2.2

Style Drift

Style drift refers to the tendency of active managers and actively managed mutual funds to deviate from their stated or expected investment style. This drift can occur gradually over time, as in the case of a "small-cap" manager buying larger and larger companies as their fund asset base grows. Style drift can also occur abruptly if an active manager perceives opportunities for higher returns from a different style. For example, a U.S. large company fund may purchase a high percentage of Mexican stocks, changing the fund’s style.


6.3

Problems

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6.3.1

Style Drift Alters Risk Exposure

Style drift creates numerous problems for active investors. It keeps them from maintaining reliable asset class allocations for their portfolios. This results in inconsistent exposure to risk and the resulting variations in expected average returns.

Experts widely agree that over time, asset class allocation is on average the single most important determinant of variance in investment performance. The best way to design a portfolio's asset class allocation is to use historical asset class data.

Active investors cannot use historical asset class data to design asset class allocations for their portfolios. Many design them by relying on style labels such as "value," "growth," "large" or "small" that are carried by active mutual funds. They may even neglect to design them at all. An active fund usually does not relate to the risk and return potential of any single asset class. It is unclear how the reliance on labels that supposedly identify these asset classes can help active investors design asset class allocations for their portfolios. This task can prove even more difficult for an active investor who invests in a separate portfolio of individual stocks and bonds. It is essentially impossible to rationally design a portfolio's asset class allocation when the building blocks of the investment strategy used to implement it are active mutual funds or individual stocks, bonds, or both.

Style drift prevents an active investor from optimally reducing diversifiable risk, because the manager of a typical active fund does not remain consistently invested in the same asset class. On the surface, this does not seem to be much of a problem, but investors who reduce diversifiable risk get a bonus. The bonus is increased return.

Style drift heightens the uncertainty felt by active investors who have little idea how their investments will perform and how their performance will relate to a discrete index. Unnecessary costs and taxes are generated in efforts to maintain consistency between a portfolio’s asset allocation and the various investments used to implement it.

The considerable latitude given to managers by active mutual fund prospectuses often results in style drift. Style labels assigned to active mutual funds by fund rating services are not particularly helpful to active investors who rely on them to design asset allocations for their portfolios. For example, an active investor who wants to design an asset allocation that includes the asset class of U.S. large company stocks may find an entire list of labeled “U.S. large company” (active) mutual funds. The problem is that the investments held by an active fund can change over time. Investors in the Fidelity Magellan Fund found this out the hard way when money manager Jeffrey Vinik shifted 30% of the fund’s assets from stocks to bonds and cash. This must have been an unwelcome surprise to investors who had chosen Magellan to earn the returns of stocks, not bonds or cash, and based their asset allocations on that expectation.

That is precisely the problem with style drift. It introduces a lot of needless uncertainty as to whether investors can implement their asset allocations, since it is likely that active funds will drift from their benchmarks. Even worse, there is no way to know which active mutual funds will survive in the future, much less which ones will be winners or losers.

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6.3.2

Style Drifters

Money manager Jeffrey Vinik's notorious fall from grace after tinkering with the popular Fidelity Magellan fund in 1996 is one of the most visible examples of style drift. Fidelity's Magellan was the world's largest mutual fund, and has been a popular equity investment. In February 1996, Magellan's asset allocation was only seventy percent equity. Vinik, the fund's manager at the time, had invested twenty percent of the fund in bonds and ten percent in short-term marketable securities, betting that long-term bonds and short-term marketable securities would outperform the equities market. Instead, the market soared to new heights, bonds fell in value, and Vinik left Fidelity. The key issue was not the outcome of Vinik's decision, but the investor's loss of control of the asset allocation process.

As recently as March 1999, Fidelity was still being criticized for misrepresenting its funds. Steven Syre and Steve Bailey, columnists for the Boston Globe, took the company to task for including stocks of mammoth companies like Microsoft Corporation and MCI WorldCom Inc. in its Fidelity Emerging Growth Fund. The fund markets itself as one that invests in small and mid-sized companies. Thomas Eidson, Fidelity's senior vice president and director of corporate affairs, conceded that Syre and Bailey had made a legitimate point.

Fidelity touted the fund's returns by comparing them to the performance of small and medium company stocks. In 1998, they performed dramatically worse than large company stocks. "It's not that uncommon for a fund to beat its competition by a few points if you're comparing apples to apples," Syre said in an interview with Brill's Content. "But this thing was blowing them away."

The Securities and Exchange Commission agreed with the journalists. Fidelity changed the fund's name to Aggressive Growth Fund and eliminated language in its prospectus that suggested a focus on smaller stocks.

A recent study by the Association for Investment Management found that approximately forty percent of actively managed funds are classified inaccurately, based on the stated goals versus actual investments. The fund managers are drifting along, chasing the latest hot trend. All actively managed funds drift from their benchmark to varying degrees. Only index funds do not drift.

One way to analyze style drift is to measure the exposure to different indexes at sequential times. Figure 6-1 illustrates the drifting styles of the Fidelity Magellan Fund from October 1983 to September 2010. The scale on the left designates the relative exposure to different styles. Note that the dark blue zone is a large value index and the light blue is a large growth index. Between January 1995 and April 2006, it would have been better to classify the fund as a large value fund, while in January 2000 it would have been a large growth fund.

Style drifters, like the managers of the Magellan Fund, are altering their styles in their quest for the next winner. As a contrast, see Figure 6-2, which illustrates the style purity of a S&P 500 Index Fund. In looking at the chart you can see an equal exposure between the large growth and large value as represented by the Russell 1000 Value and Russell 1000 Growth.

Figure 6-1

Figure 6-2




Figures 6-3 through 6-5 show the style drifting of several well known mutual funds, 6-6 and 6-7 are required to show the several asset classes the the Legg Mason Value trust tracked over a 25 year period and 6-8 shows the style consisitency of Vanguard's S&P 500 Index Fund.

Figure 6-3

Figure 6-4

Figure 6-5

Figure 6-6

Figure 6-7

Figure 6-8



Figure 6-9 compares the styles of the Scudder Large Value Fund over time to a DFA Large Value passively managed index fund in Figure 6-10. Finally, Figure 6-11 compares the Vanguard Explorer Fund, which is described by Morningstar as a small growth fund. As a comparison, see the DFA Small Value Index Fund in Figure 6-12. Because of the undesirable characteristics of small growth, DFA does not offer a small growth index fund. In each comparison the bottom index fund provides more consistent and style pure risk exposure.

Figure 6-9

Style Drift of Scudder Large Value

Figure 6-10
Relative Style Purity of DFA U.S. Large Value

Figure 6-11

Style Drift of Vanguard Explorer

Figure 6-12
Relative Style Purity of DFA U.S. Small Value

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6.3.3

Style Drift and the Fama-French Risk Factors

Fama and French identified risk factors in 1992 that highly correlate with long-term historical returns, namely company size and value orientation. Style drift between these two factors for two periods of approximately fifteen years can be seen in Figure 6-1. On the horizontal axis, Value is a high Book-to-Market ratio (BtM) and Growth is a small BtM. On the vertical axis, Small and Large Cap are companies with small and large market capitalization, respectively. The numbers on the axes are measures of market exposure to each of these asset classes. The 0,0 point (the crossing of the axes) essentially represents the entire market. It reflects all of the stocks in the CRSP database and is the reference for the other measurements.

The green points reflect the average exposure of the funds during the period between January 1976 and June 1988. The white points reflect average exposure during the period between July 1988 and December 2000. Note how far some funds moved from their starting point. This movement reflects Style Drift and is often an unannounced change in investment objectives. Other funds barely moved. It should be noted that the data fails to reveal the many additional shifts in positions that these funds made within each of the years depicted. These additional shifts drive up trading costs, generate higher taxes, alter risk, and lower returns.

One of the reasons it is so dangerous to style drift is because styles are as unpredictable as stocks, times, or managers. Take a look at how the style of the year changes over time in the table below. Just follow the light blue International Small Company, which goes from highest to lowest and back to highest in the first three years. Can you pick the next winning style? It is no wonder that both professional and amateur investors are whipsawed into investing in different styles. But investors who hold onto diversified portfolios obtain the returns and losses of all top performing asset classes over time. This method has been shown to substantially improve your returns.

Figure 6-13



Style Picking


Before discussing the next set of tables, please refer to Figure 6-8, which provides a legend for the portfolio and index buttons on Tables 6-1, 6-2, 6-3 and 6-4. For further information about these buttons see Appendices A and B.

One of the reasons it is so dangerous to style drift is because future style winners are as unpredictable as stocks, times or managers. Table 6-1 shows the annual returns of the S&P 500 and 20 index portfolios of different style over the last 80 years. Some investment managers use a strategy referred to as tactical asset allocation. This is a form of style picking where a manager alters the allocation of styles based on their prediction of the future style winners. To illustrate how difficult it is to predict the next winning asset allocation of styles, refer to Table 6-2, which is ranked each year with the highest return for that year on the left and the lowest return on the right. The random rotation of styles from left to right illustrate the difficulty style drifters have in picking the next winning style.

Table 6-3 provides the annual returns of the 15 IFA Indexes and the total market index from CRSP for the last 80 years. In Table 6-4, the returns are sorted so that the highest is on the left. Note the random rotation of individual indexes or styles from year to year is virtually impossible for managers to predict. It is no wonder that both professional and amateur investors are whipsawed into investing in different styles. But, investors who hold onto diversified portfolios obtain the returns and losses of all top performing asset classes over time. This method has been shown to substantially improve your returns.


  button legend

Figure 6-14



Figure 6-15



Figure 6-16



Annual Returns of 20 IFA Index portfolios and 15 IFA Indexes

Figure 6-17



Figure 6-18

Figure 6-18B



6.3.4

Tactical Asset Allocation: The Market-Timing Wolf in Sheep's Clothing

Borrowing the definition from a recent Vanguard study,

"Tactical asset allocation (TAA) is a dynamic strategy that actively adjusts a portfolio's strategic asset allocation (SAA) based on short-term market forecasts. Its objective is to systematically exploit inefficiencies or temporary imbalances among different asset or sub-asset classes."

To put it more succinctly, TAA is simply market-timing but with only a set portion of the whole portfolio. For example, an institution may have an SAA of 60% equities and 40% fixed income, but utilization of TAA may allow the equity allocation to vary between 50% and 70% and the fixed income allocation to vary between 30% and 50%. This is equivalent to saying that 80% of the portfolio will have a 60/40 allocation while market-timing (or style-picking) will be performed with the remaining 20%. For institutional investors, TAA occurs at two levels: Investment consultants allocating funds among different asset class managers and investment fund managers allocating funds among different asset classes and sub-asset classes.

It is IFA's position that TAA is a futile exercise because market-timing and style-picking are unproductive at best, and potentially quite destructive at worst. TAA is merely one more attempt by active consultants and managers to deliver the ever-elusive alpha, which as shown in a previous article, has not been reliably achieved through security selection.

TAA is normally built on models that rely on "signals" to determine when to go heavy on one asset class at the expense of another. A well-known example is the "Fed model" which compares the earnings yield on equities to the yield on 10-year Treasury Bonds. If the earnings yield (the inverse of the price-to-earnings ratio) on the S&P 500 were to fall below the 10-Year Treasury yield, a manager utilizing TAA based on the Fed model would interpret this difference as a clear signal to favor fixed income at the expense of US equities. The Fed model, like all the other models used for market-timing, has repeatedly been shown to be unreliable in both the short-term and the long-term. For further details, see Asness, Clifford, "Fight the Fed Model", Journal of Portfolio Management, Fall 2003. Another type of signal commonly relied upon is based on market sentiment. Data points such as the amount of stock owned on margin or the amount currently sold short can be taken as indicators of whether the market is "overbought" or "oversold". Recently, The Wall Street Journal ran a column by Brett Arends entitled, "You Should Have Timed the Market" where he advocates using mutual fund cash flow data take a contrarian position from what the general investing public is doing. Of course, anyone who seriously would attempt to use these numbers to time the market would find it to be a vexing exercise because they change direction quite frequently. One problem with trying to read market sentiment for timing purposes is that sentiments can endure for years at a time. As John Maynard Keynes famously remarked, "The market can remain irrational longer than you can remain solvent."

The reason why all these models are unreliable is so simple that it is easily overlooked. In three words, prices are fair. This means that every asset class has thousands of intelligent and informed people opining daily on the risks of the asset class in general and all the securities contained in the asset class in particular. As a result of the discovery process, prices are set so that buyers can expect a return that is commensurate with the risk they assume. If an institution (or a consultant acting on its behalf) decides that an asset class is overvalued and thus should be pared back, the party taking the other side of the trade has the full expectation that they will be compensated appropriately for the risk they are taking. There is absolutely no reason for the institution or the consultant to assume that it has special proprietary knowledge that the rest of the market is lacking.

Now that IFA's theoretical objections to TAA have been outlined, it would be useful to examine how mutual funds built on TAA have performed over a long period of time. In the Morningstar Direct® database as of 9/30/2010, there are only 20 "Moderate/Conservative/Aggressive Allocation" funds that have 20 years or more of returns data. Of these 20, only 4 plot above the line of IFA portfolios on a reward vs. risk chart.

Figure 6-19

While 4 out of 20 (20%) is rather dismal to begin with, the true percentage is much lower because we are only looking at the funds that survived for the last 20 years. Given that there are 129 such funds in existence as of 4/30/2011, it is not unreasonable to assume that a similar number existed 20 years ago. In fact, this would correspond to an 9% mortality rate among these funds which we know is close to the observed average of 7% for all mutual funds. This means that an investor who chose a tactical allocation fund 20 years ago had only about a 3.1% chance of both keeping the same fund and beating a risk-equivalent strategic allocation of index funds. These are not very good odds, and certainly not good enough to stake something as important as employee's retirement security or charitable funds held by a foundation or endowment.

As far as the ability of investment consultants to add value by moving funds from one manager to another, this myth was completely debunked in "Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors" (Financial Analysts Journal, Nov/Dec 2009). The authors evaluated over 80,000 investment decisions by plan sponsors (or consultants acting on their behalf). As the chart below shows, in only two out of eighteen years did plan sponsor decisions to move assets from one manager to another add value. The authors estimate that over $170 billion of investment value was destroyed over the period (1984 to 2007).

Figure 6-20

To summarize, TAA is simply one more attempt by Wall Street to package up luck and sell it as skill. Institutional investors are better off with a sensible strategic allocation of low-cost index funds that reflects an appropriate risk level. Market-timing and style-picking should never be utilized for either a portion of or the whole portfolio.

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6.4

Solutions

The simple solution to style drift is to relinquish active investing and invest in index funds. An index fund manager prevents style drift by investing only in the stocks that meet specific rules of ownership, regardless of market conditions. For example, the manager of the DFA U.S. Large Cap Value Fund follows a set of rules that defines which stocks the fund will hold and does not deviate from that criteria, even if large cap value stocks had a bad year. Firms like Dimensional Fund Advisors strictly adhere to specific parameters to maintain reliable exposure to many asset classes, such as U.S. large value, U.S. small value, or emerging market value stocks. Their portfolio managers have no discretion to purchase stocks that do not meet those parameters, and no financial incentive exists for them to deviate from their very specific disciplines that define the asset class.


6.5

Summary


An active investment strategy complicates a portfolio's asset class allocation with style drift. Indexing is the only solution to the problems caused by style drift in active investing, because asset class allocation is always on target.

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6.6

Review Questions


become a certified indexer

Please answer the following questions before moving on to the next Step:

1. What percent of actively managed mutual funds engage in some degree of style drift?

a) five percent
b) thirty percent
c) forty percent
d) fifty percent
e) one hundred percent

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2. Style Drift is best described as:

a) money managers who stop wearing pin-striped suits
b) Morningstar’s five-star funds
c) index mutual funds
d) change in investment objective
e) casual Friday on Wall Street

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3. Actively managed funds tend to "drift" from their defined investment style because:

a) fund managers go on vacation
b) fund managers retire
c) fund managers chase the hot asset class
d) fund managers stick to their described objectives
e) fund investors force fund managers to drift

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4. Jeffrey Vinik is important in the history of style drift, because he:

a) discovered it
b) developed the style system
c) was the most visible example of style drift
d) cured style drift
e) wrote a book about style drift

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5. Index fund managers avoid problems with style drift by:

a) purchasing stocks outside their investment criteria
b) selling stocks that meet their investment criteria
c) selling stocks that no longer meet their fund's objective
d) purchasing stocks that fit their investment criteria
e) Both c and d
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